A U.S. taxpayer must carefully assess whether his activity gives rise to an actual trade or business or a hobby conducted for pleasure or recreation. The distinction is crucial because it determines how taxpayers report the income and expense connected with the activity.
A taxpayer analyzes many factors in doing this assessment; however, the principal consideration for the IRS is that businesses operate to make a profit while a hobby has no for-profit motive.
IRS Provided List of Factors to Consider
The IRS provides a list of factors to consider when determining whether an activity is a for-profit business venture or a hobby. Some of the key factors include, but are not limited to, the following:
- The taxpayer carries out the activity in a business like manner.
- The taxpayer puts sufficient time and effort into the venture to show his intent of trying to make a profit.
- The taxpayer’s early business losses are normal for startups in the same business sector.
- The taxpayer is regularly modifying their business strategy and make changes to achieve profitability.
- The taxpayer was successful in making a profit in similar activities in the past.
Hobby Income, Deductions and Losses
Under IRC Section 183(a), in the case of an activity engaged in by an individual or an S corporation, if such activity is not engaged in for profit, no deduction attributable to such activity shall be allowed.1
If a taxpayer has a hobby activity and generates gross income from the activity, the taxpayer must report the gross income on their federal income tax return. However, the taxpayer cannot deduct any expenses against those revenues. The taxpayer reports hobby income on Schedule 1 (Additional Income & Adjustments).
As a result, a taxpayer can never claim a hobby loss to offset other income.
Trade or Business Income, Deductions and Losses
When a taxpayer conducts an active trade or business, they must report their gross income from the trade or business and are allowed to deduct eligible trade or business deductions as permitted under IRC Section 162. A sole proprietorship would report their income and expenses from a trade or business activity on Schedule C (Profit or Loss From Business). The net result is either positive taxable income or a net taxable loss for the year.
Taxpayers can generally claim net business losses against their other income. A taxpayer must, however, consider other limitations, such as the passive activity loss (PAL) rules, basis limitations, and at-risk limits, before deducting business losses.
Three-Year Loss Presumption
If an activity generates a net loss for three or more taxable years within five years, there is a presumption the activity is not engaged in for profit.2 A taxpayer may consider filing IRS Form 5213 to extend the period by one additional year.
Video Tutorials on Form 5213
Please view our video here for a discussion on the hobby loss rules and how to complete Form 5213
Additional Information
Taxpayers seeking more information can visit the IRS website for discussions on the key differences between a hobby and a business, how to account for side hustle income & expenses, and the IRS Publication 334 (Tax Guide for Small Business).